FINANCIAL TOOL
Treynor Ratio
This is an equation that measures the following:
How much reward has an investor received in relation to the amount of market risk taken?
This is similar to last week’s financial tool: the Sharpe ratio. But it’s different.
The Treynor ratio specifically shows investors which investments have generated the greatest reward for each unit of added market sensitivity (called “systematic risk”).
Treynor Ratio =
Return of the portfolio – (Risk-free rate)
Beta of the portfolio
A beta of 1 means that the portfolio has historically moved 1:1 with the market it’s tracking. A beta of 1.3 means it has moved $1.30 for every $1.00 that the market moved, on average. And so on.
A higher beta indicates bigger movements up and down in relation to the broader market, while a lower Beta indicates less movement.
Example:
Investment A
Averaged 10% over 3 years
Beta of 1
Investment B
Averaged 11% over 3 years
Beta of 1.3
If we say the risk-free rate is 5%, then:
Treynor Ratio
Investment A: 5.0
Investment B: 4.6
What this tells us is that even though Investment A made a lower return, the unit of return per unit of market risk was actually higher than Investment B.
In other words, A achieved better results when adjusted for risk.
It’s sort of like saying, I’d rather pay $1 for one apple than $2.60 for two apples. Even if I’d prefer to have two apples!
Weaknesses in this method of risk-reward comparison include:
-
- This ignores unsystematic risk (which becomes important if there is high concentration in any one company). It assumes a well-diversified portfolio.
- This only measures past numbers which are not indicative of what they will be in the future.
Next time you’re comparing investment returns, consider using the Treynor Ratio to estimate if you’re likely overpaying with risk for the achieved return.